Should You Invest Like a Bank?
Banks make money by taking in deposits and then lending out the deposits at a higher rate of interest. The gross profit or “spread” on such lending is relatively small such as 2 to 3%. After accounting for all of its costs a bank often makes a net profit on each dollar loaned out of about 1% per year.
This 1% return on assets is then typically increased to a return on share owner equity of 10 to 20% through the use of leverage. Banks typically have common equity of only 5 to 10% of their assets. In the simplest cases the assets consist almost entirely of loans receivable. Share owner money funds only 5 to 10% of the loans. The remaining 90 to 95% of the money loaned out is funded largely by deposits from the banks customers and to a small degree by bank preferred share and debt investors. I explain this and how banks make money in more detail in a related article.
Leveraging an investment 10 to 20 times, as banks do, could be very dangerous and could easily result in a total loss of the equity investment or even losses well beyond the equity investment. Banks are able to operate with very high leverage because they are very careful about how they lend out their money. Much of their lending is insured residential mortgage lending where government guarantees protect the bank against loan losses. The remaining lending often has security pledged against the loan. In addition, banks carefully consider the credit rating and the earnings level and stability of each borrower. Also, the most that bank common share owners can lose is their total equity investment. Any losses beyond that would be suffered by preferred share investors, debt investors, government deposit guarantee funds and uninsured depositors.
The question arises as to whether an individual investor could emulate a bank by borrowing money at a low rate and investing the money into a relatively safe asset that pays a higher interest rate. This article explores that question.
Many individuals have access to a secured line of credit at an interest rate in the range of 3.2%. Investment margin accounts are available for use at 3.0%. Mortgage money can be borrowed on a five-year variable rate basis at 2.0% or a three year fixed rate at 2.14% or a five year fixed rate at 2.42%. These interest rates are applicable as I write this article but are subject to change.
Meanwhile, there are many securities that pay cash yields that are higher than these borrowing costs which results in a positive “spread” that can be accessed by investors. For example, bank perpetual preferred shares yield 5.0 to 5.5%
Consider the option of taking out a five-year fixed rate mortgage at 2.42% and investing in a bank perpetual preferred share at about 5.4%. The spread would be about 3.0%. With such a small spread it takes a large investment to result in a meaningful annual cash flow. For example, if you had the equity available, a $400,000 mortgage could be used in this manner to generate $12,000 per year or $1000 per month.
While $12,000 per year is nothing to sneeze at, it does not strike me as sufficient incentive for taking out such a very large mortgage. Also there would be a risk that the bank preferred shares would decline in value and not recover. The $12,000 would be about $10,720 after tax based on Ontario tax rates for someone with a $100,000 taxable income. Strangely enough, the $12,000 would increase to $13,490 after tax in Ontario for a taxable income of $50,000. This is because the tax credit on the interest would exceed the tax paid on the dividends due to the very low tax rate on eligible dividends that applies at lower levels of taxable income.
It would be safer to undertake this spread strategy with a bond investment it it were feasible to do so. A high-grade bond of say 5 years or less duration could be counted on to mature at a set amount to repay the loan. Unfortunately, such corporate bonds generally yield under 3.0% (except for riskier issues) and therefore offer little to no spread over available borrowing costs. For example, there is a Bank of Nova Scotia bond that matures in five years that yields only 2.1% based on the ask yield at TD Direct.
It may be possible to find reasonably safe dividend yields as high as 7.0%. In this case our spread over the five-year fixed mortgage rises to 4.6%. A $400,000 mortgage could then generate a more motivating net cash flow of $18,400 per year before tax. In Ontario, with a $100,000 taxable income this would be about $16,440 after tax. Keep in mind that this amount of dividends would add substantially to taxable income.
Perhaps at spreads of 4.0% and higher this borrowing-to-invest strategy may be worthy of consideration for some investors. However, this would not come without risks. Any investment that is yielding in the range of 7% or more is risky. It can drop in value. It could perhaps even become worthless. The dividend could be cut or eliminated. The debt meanwhile would still exist. Spreading the investment over several securities would reduce the risk but not eliminate it.
Even if the investment works out as planned the investor has used up some or most of their borrowing capacity. That borrowing capacity would not be available for other needs or better investment opportunities that might arise.
On of the problems with borrowing to invest is that mortgages and most lines of credit require more than an interest-only payment.
Using a margin account for some or all of borrowing can be convenient because the payments will be interest-only and the payments will be deducted automatically by the bank. Keep in mind that margin debt is usually personally guaranteed. Even if the investments became worthless you would still owe the margin loan. And margin loan principle has to be partially repaid immediately if the securities have been fully margined and then drop in value.
Rather than borrow and invest at a yield spread like a bank does another strategy would be to borrow and invest in bank common shares.
Royal Bank has a dividend of 4.2%. That’s enough to cover the borrowing interest costs with a little left over. And due to the Bank’s profitability, driven by the Bank’s high leverage, the share price is likely to increase over the years. But a share price increase is in no way guaranteed. Under certain senearios there could be major losses on the bank shares and the dividend could be cut or eliminated.
Borrowing to invest is risky. It’s certainly not something that everyone should consider. But for some investors it is worth considering. A 3 or 4% yield on your own money may not be exciting, but as banks are well aware, earning 3 or 4% on someone else’s money is another matter.
Another possibility when it comes to banks is to simply invest in their shares without leverage. This is far less risky and is likely to work out satisfactorily over the years.
November 30, 2015